Oil and Gas Accounting: Methods, Need and Implications

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Oil and Gas Accounting: Methods, Need and Implications

Introduction

Accounting for oil and gas firms has been debated since the 1970s. Companies in the industry vary in size and degrees of integration ranging from one-man operations to large multinational corporations. With increasing government code of practices, complicated and more arduous tax laws, and diversification in the internationaloil and gas market, the complexities of the industry have reached on all the time high, with a large number of uncertainties. An increased risk associated with discovering economical production, it can be estimated that one out of ten wells drilled ever finds the oil and gas reserves, and that only one out of forty wells drilled ever finds enough reserves to be considered economically productive (Schugart G., 2002). The alternatives used in financial accounting and reporting by oil and gas producing companies have been grouped under two basic methods of accounting- the successful efforts (hereafter referred as SE) method and the full cost (hereafter referred as FC) method. Numerous academic studies have been carried out in order to answer the questionthat which historical cost accounting method i.e., SE or FC best captures the underlying economic transactions. Unfortunately, it is still unresolved.

The purpose of this study is to assess the implications of accounting methods for oil and gas companies. This study proceeds as follows: Section II reviews the need of accounting methods for an oil and gas company. Section III discusses the definition and differences between the two methods i.e., SE and FC respectively. Section IV contains the impact of differing levels of cost assets and financial statement. Section V provides the conclusion and implications.

Need for Oil and Gas Accounting Methods

The accounting method that a company chooses affects how its net income and cash flow numbers are reported (Vitalone J. W., 2009). Managersmaybehaveopportunisticallybychoosingtheaccountingmethod thatwillmostlikelyincreasetheircompensationoverthenextfewyears,ratherthanselecting the accounting method that will provide the most value-relevant information to investors. Alternatively, managers may select an accounting method based on its ability to convey the economics of the firm’s activities to investors in a transparent manner, and different companies select different methods because of subtle differences in their operations, financing, corporate governance, etc (Bryant L., 2003). Therefore, when analyzing companies involved in the exploration and development (E & D) of oil and natural gas, the accounting method used by such companies (based in UAE and abroad) is an important consideration.

Methods for Oil and Gas Accounting

SE Method

The basic concept underlying the successful efforts method of accounting for oil and gas E & D activities follows the premise that an enterprise is to capitalize only those costs it incurs that directly result in an asset that has future benefit measured in terms of future cash flows.For unsuccessful (or "dry hole") indirect results, the associated operating costs are immediately charged against revenues for that period.

FC Method

The basic concept underlying the full cost method of accounting for oil and gas E & D activities follows the premise that an enterprise is to capitalize both successful and unsuccessful (or direct or indirect) E & D costs, regardless of the outcome.

The primary difference between the SE and FC methods is the timing of the expense or loss charge against revenue (Charlotte J. Wright, ‎Rebecca A. Gallun, 2008). The other basic difference between the two accounting method is the size of the cost center over which costs are accumulated or amortized. For SE, cost center is a lease, field, or a reservoir. While for FC, the cost center is country.

Impact of Differing levels of Cost Assets and Financial Statement

The conflicting accounting treatment of unsuccessful exploratory drilling costs under SE versus FC can have substantial impact on the income statement of oil and gas companies. A company with a large tentative drilling program and a normal unsuccessful drilling rate would have a significant amount of dry-hole expense under SE. Those dry-hole costs would adversely affect the net income of the SE based company. On the other hand, a full cost company would capitalize the exploratory dry-hole costs and therefore these costs would typically have no immediate effect on the net income(Charlotte J. Wright, ‎Rebecca A. Gallun, 2008). The net income can be reduced through future amortization.

Table 1 Summary of pros and cons of SE and FC

Item

Successful Efforts

Full Cost

Acquisition Costs

Capital

Capital

G & G Costs

Expense

Capital

Exploratory dry hole

Expense

Capital

Exploratory well, successful

Capital

Capital

Development dry hole

Capital

Capital

Development well, successful

Capital

Capital

Production costs

Expense

Expense

Amortization cost center

Property, field or reservoir

Country

Used By

Large companies

Small/ startup companies (Some large companies in USA also use FC.

Ceiling tests

Not required

Required

Impairments

Not Common, less

Frequent

In SE, operating income, net incomeand property, plant and equipment (PP & E) is lower.While in FC, the operating income, net income and PP & E is always higher.

Conclusion and Implications

This study provides evidence on which of two alternatives accounting methods for E&D expendituresbetterexplains the companyvalue.The impact of two accounting methods namely SE and FC on capital assets and financial statements is discussedexplicitly. Moreover, SE method is beneficial for the large companies becauseit highlights failures and the risks involved in the search for oil and gas reserves by charging to expense costs that are known not to have resulted in identifiable future benefits.On the other hand, FC method is suitable for small or startup companies, as it requires high operating income. Eventually, a policy of full capitalization of expenditures with uncertain future economic benefits better summarizes information relevant to investors relative to a policy of partial capitalization (SE). But other factors are of more concern than these. Because FC methodcapitalizes the costs of unsuccessful property acquisitions and unsuccessful activities as part of the costs of successful acquisitions and activities, and then tends to obscure failure and risk.This could be alarming for a large company value. Additionally, theadverse effect on net income of expensing exploratory dry hole costs may be significantfor small companies working under SE. Therefore, when investing in companies involved in E & D of oil and natural gas reserves, company analysis should include identifying which accounting method a company must follow. The differences between the two methods and their impact on near and long-term net income and cash flow should prove helpful when comparing individual companies' past results and future expectations (Vitalone J. W., 2009).Theseconclusionsprovideevidencethatisusefultoaccountingstandardsetters,investors, and others interested in accounting for expenditures with uncertain future benefits.

References

Bryant L. (March, 2003). Relative Value Relevance of the Successful Efforts and Full Cost Accounting Methods in the Oil and Gas Industry, Journal of Review of Accounting Studies, Springer, Volume 8, Issue I, doi: 0.1023/A:1022645521775, pp. 5-28.

Charlotte J. Wright, ‎Rebecca A. Gallun(2008). Fundamentals of Oil and Gas Accounting, 5th Edition, PennWellCorporation, ISBN No.: 978153701376

Schugart G., (2002). Oil and Gas Accounting - Part 1, Institute for Energy, Law & Enterprise, University of Houston Law Center. http://www.beg.utexas.edu/energyecon/Uganda/Oil-&-Gas-Accounting-1.pdf

Vitalone J. (November 21, 2009). Accounting for Differences in Oil and Gas Accounting. http://www.investopedia.com/articles/fundamental-analysis/08/oil-gas.asp

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